Recent actions by the Trump Administration are altering the structure of international trade. In this article, the author examines the revamping of the North American Free Trade Agreement. Is an amicable renegotiation of NAFTA probable in the near future?

On July 17, 2017 the Office of the United States Trade Representative (USTR) released its “Summary of Objectives for the NAFTA Renegotiation” detailing the Trump Administration’s goals for “NAFTA 2.0”. The eagerly awaited document reveals the Administration’s opening position in the forthcoming talks between Canada, Mexico, and the US to revamp the North American Free Trade Agreement.

The USTR document signals an easing of the Trump Administration’s stance on NAFTA. During the 2016 presidential candidate, then candidate Donald Trump declared his intention to exit what he called the “worst trade deal” in US history. During the early months of the new administration, President Trump continued his strident rhetoric about NAFTA, which he claims has decimated US manufacturing. But following personal appeals by Canadian Prime Minister Justin Trudeau and Mexican Prime Minister Enrique Peña, on April 27 Trump withdrew his threat to scuttle NAFTA. On May 18, the Administration formally notified the US Congress of the launch of a trilateral renegotiation of the 23 year old trade agreement.

Supporters of NAFTA in all three countries agree on the need to modernise the agreement, whose formation in 1994 preceded the emergence of the digital economy, the expansion of global value chains, and other shifts in the economic and technological landscape that have transformed international trade. Many of the measures needed to upgrade NAFTA had already been settled in a separate regional trade agreement: The Transpacific Partnership (TPP), the 12-member pact that was concluded in February 2016 after seven arduous years of negotiation. TPP has been heralded as the gold standard in international trade agreements, featuring chapters on cross-border data flows, intellectual property rights, environmental protection, labour standards, and other provisions aligned with the 21st century world economy. Canada and Mexico belatedly joined TPP, offering concessions to the United States (also a TPP signatory) on NAFTA-related trade to expand their access to a huge Asia-Pacific market representing one-third of global trade.

With a total merchandise trade turnover of $5.4 trillion, NAFTA is the world’s second largest trading block behind the European Union ($10.7 trillion).

But President Trump’s announcement on January 23, 2017 (three days after his inauguration) of the US withdrawal from TPP altered the strategic calculus of Canada and Mexico, which must now negotiate regional trade issues within the trilateral framework of NAFTA. Ironically, the decision of Donald Trump (who prides himself as a master dealmaker) to withdraw from TPP weakens the US bargaining position with Canada and Mexico, which will prove less willing to compromise on NAFTA-specific trade than on accessing the $28 trillion TPP market.

The renegotiation of NAFTA thus promises to be a highly contentious affair, with the two smaller members poised to resist efforts by their larger neighbour to craft regional trade rules hewing to Trump’s “America First” project.

NAFTA in the World Economy

With a total merchandise trade turnover of $5.4 trillion, NAFTA is the world’s second largest trading block behind the European Union ($10.7 trillion). Between 1994 and 2016, global exports of goods by the three NAFTA countries grew from $738 billion to $1.7 trillion. During the same period, NAFTA’s global service exports grew from $220 billion to $480 billion. (See Figure 1.)

Intra-regional commerce represents one-half of NAFTA’s global exports, illustrating the expanding role of regional production networks operating across the three member countries. Among rest-of-world trading partners, Asia and Europe receive the largest shares of global NAFTA good exports (20.4 and 15.6 percent respectively). Machinery and transport represent the largest share (43.4 percent) of goods exported by NAFTA. Within NAFTA’s increasing stock of service exports, travel (29.2 percent), financial services (15.2 percent), and use of intellectual property (15.2 percent) comprise the biggest categories. (See Figure 2).

Figure 2: Structure of NAFTA Trade

Destination and Composition of NAFTA Exports, 2015

Source: WTO World Trade Statistics

In addition to boosting intra-regional and extra-world trade, NAFTA has stimulated foreign direct investment in North America. Between 1994 and 2015, inbound stock FDI in NAFTA rose from $901 billion to $6.8 trillion (UNCTADstat). Canada and the United States (which entered a bilateral free trade agreement in 1987) were already leading destinations of foreign direct investment by the time of NAFTA’s formation in 1994. The accession of Mexico (heretofore not a major FDI site) prompted economic/legal/regulatory reforms that enhanced that country’s attractiveness to foreign investors.

Multinational Value Chains in NAFTA

The bulk of foreign investment in NAFTA comes from multinational corporations in key global industries (aerospace, automotive, chemicals, energy, telecommunications, etc.) enlarging their North American footprints. The local content requirement for duty-free access to the NAFTA market (62.5 percent) has incentivised foreign multinationals to boost value-added production at their North American subsidiaries. To meet the local content threshold, Japanese car manufacturers that first entered North America in the 1980s (Honda, Nissan,Toyota) upgraded their regional subsidiaries from simple assembly plants to engine manufacturing, research and development, and other high value added functions.

The growth of foreign trade and investment in NAFTA has accelerated the rise of multinational value chains in advanced manufacturing, with extensive movement of raw materials, semi-processed goods, components, and finished products across national borders. Intermediate inputs account for 50 percent of trade between the US, Mexico, and Canada. A large share of intermediate input trade in NAFTA stems from intra-company transfers (related party trade and majority-owned affiliate trade), demonstrating multinational control of complex North American supply chains. Volumes of cross-border intermediate trade are particularly high in US states that rely on Canadian and Mexican imports: e.g. Washington State in aerospace components, Texas in energy products, Michigan in automotive parts.1

The growth of foreign trade and investment in NAFTA has accelerated the rise of multinational value chains in advanced manufacturing, with extensive movement of raw materials, semi-processed goods, components, and finished products across national borders.

Regional production networks play an especially critical role in the NAFTA automotive industry. Since 2011, Mexico has received 9 of 11 new automotive assembly plants announced for North America. In addition to US-based automotive companies (Ford, General Motors, Fiat Chrysler), leading foreign car manufacturers (Audi, Daimler, Honda, Kia, Mazda, Nissan, Volkswagen) are expanding production

capacity in Mexico. A major share of cars assembled in Mexico is exported to the United States, contributing to a large merchandise trade deficit that underpins the Trump Administration’s claims about unfair trade in NAFTA. However, the imbalance in gross trade neglects the high import content (nearly 20 percent) of US-manufactured, value-added components (drive chains, electronic systems, etc.) embedded in Mexican-assembled cars destined for the American market.2

Trade Balances in NAFTA

The automotive case illustrates President Trump’s fixation on trade deficits as a measure of the economic damage supposedly inflicted by international trade deals consummated by previous US administrations. The very first item in USTR’s summary of objectives is “to improve the US trade balance and reduce the trade deficit with the NAFTA countries”.

As shown in Figure 3, the US does indeed run trade deficits with both Canada and Mexico ($20.8 billion and $63.9 billion respectively in 2015). But these deficits emanate from imbalances in goods trade between the US and its NAFTA partners, which illustrate the relative positions of the three countries in regional production networks. The US runs bilateral surpluses in service-related trade, demonstrating the country’s comparative advantages in high value services (design and engineering, research and development, etc.). Moreover, as noted above the gross trade figures (which report the full value of final assembled products exported from Canada and Mexico to the United States) obscure the high import content of intermediate goods manufactured on the US side.

• Economists broadly agree that regional trade agreements like NAFTA have little impact on global balances of exports and imports. Trade deficits and surpluses are chiefly the result of macroeconomic factors, namely (1) the balance between domestic absorption and domestic production and (2) the relationship between savings and investment. The long-standing US trade deficit reflects the propensity of Americans to consume products in volumes surpassing domestic production capacity, driving demand for foreign imports.3

• While large in absolute terms, the US global trade deficit is not particularly big relative to GDP (2.7 percent). Furthermore, as the world’s largest economy that holds the principal reserve currency, the United States is uniquely positioned to finance its trade deficit via inflows of foreign capital.
• Canada and Mexico are not the leading sources of the US global trade deficit. China is by far the biggest contributor to that deficit ($347 billion in 2016, equivalent to 40 percent of the US current account deficit worldwide). American trade deficits with Japan and Germany also exceed the bilateral imbalances with Canada and Mexico.
• Canada and Mexico are themselves deficit countries in international trade. In fact, as a share of GDP the global trade deficits of Canada and Mexico exceed that of the United States. It is therefore unlikely that the two countries will yield to American browbeating to reduce their bilateral surpluses with the US, which would merely increase their global deficits.

Rules of Origin

The USTR document calls for a strengthening of rules of origin “to ensure that the benefits of NAFTA go to products genuinely made in the United States and North America”. This statement is a red flag for companies undertaking cross-border operations in North America, which already confront high costs of compliance with NAFTA Chapter 4 Rules of Origin.

The purpose of these rules is to certify that products and services entering the NAFTA zone actually originated from Canada, Mexico, or the US. Enforcement of such rules is difficult in an era when multinational corporations source thousands of intermediate inputs across complex global supply chains, with value-added operations undertaken at multiple points in the transnational value chain.

To qualify for duty-free treatment, multinationals operating in NAFTA must present detailed documentation of the country origin of imported products. If they still fall short of the local content threshold, these companies are forced to replace externally imported inputs with costlier regionally sourced inputs, raising production costs and creating welfare losses for consumers. The burden of rules of origin compliance has proven onerous for small and medium enterprises active in NAFTA, which increasingly opt to pay WTO tariffs on imported products (ranging in the low single digits in many industries) rather than endure the paperwork and administrative costs of certifying North American content.4

NAFTA’s status as a free trade agreement and not an EU-type customs union further complicates enforcement of Chapter 4 Rules of Origin. The three member states apply their own rest-of-world tariffs governed by the World Trade Organization. Canada, Mexico, and the US are also members of an assortment of bilateral trade agreements with countries outside NAFTA. Lacking a common external tariff on extra-regional imports, companies operating in NAFTA must undertake complex calculations on the source and destination of intermediate inputs.

The Transpacific Partnership presented an important opportunity for the three NAFTA countries to streamline and simplify their rules of origin. By cumulating rules of origin across the 12 member states and reducing local content requirements, TPP would have lowered the costs of regulatory compliance within NAFTA and facilitated the extra-regional operations of North American-based companies. But the

US withdrawal from TPP has removed this option, leaving Canada and Mexico with the challenge of negotiating with an administration intent on devising rules of origin aimed at advancing Trump’s “Buy American, Hire American” campaign.

Trade Disputes

The USTR document also provides ominous signs of the Trump Administration’s intentions regarding trade disputes with Canada and Mexico. In the NAFTA renegotiation, the Administration seeks to:

• “Preserve the ability of the United States to enforce rigorously its trade laws, including the antidumping, countervailing duty, and safeguard • “Eliminate the NAFTA global safeguard exclusion so that it does not restrict the ability of the United States to apply measures in future ” • “Eliminate the Chapter 19 dispute settlement mechanism.”

Commensurate with NAFTA’s standing as a preferential free trade area, Chapter 19 was designed to reduce friction and expedite resolution of intra-regional trade disputes. North American companies contesting AD (anti-dumping) and CVD (countervailing duties) cases can appeal to binational expert panels to undertake independent, impartial reviews. This mechanism provides an alternative to costly litigation in domestic courts and lessens dependence on the cumbersome multilateral procedures of the World Trade Organization.

NAFTA has also exempted Canadian and Mexican companies from applications of two trade remedies in

US federal law: (1) Section 232 of the 1962 Trade Expansion Act, which authorises the US Secretary of Commerce to investigate foreign trade matters affecting national security; and (2) Section 201 of the 1974 Trade Act, which empowers the US President temporarily to impose duties and non-tariff barriers to protect American industries threatened with import competition.

These provisions succeeded in limiting the application of trade sanctions within NAFTA. While the three countries have initiated a number of AD/CVD/201/232 actions against extra-regional countries (with China the most frequent target), intra-regional disputes have proven infrequent (affecting just 1.3 percent of US and Mexican imports from NAFTA and 0.1 percent of Canadian imports from NAFTA).

The election of Donald Trump signals a major shift in US policy on intra-regional trade disputes. Within the first 100 days of Trump’s presidency, the share of Canadian/Mexican imports covered by US trade sanctions jumped to 6.4 percent. That share will doubtless rise if the administration achieves its declared goal of eliminating NAFTA Chapter 19, which will expose Canada and Mexico to AD/CVD actions previously limited to extra-regional countries.

Equally worrisome, Trump’s removal of the NAFTA global safeguard exclusion would allow the US to apply Sections 232 and 201 to its North American partners. This raises the spectre of Canada and Mexico’s inclusion in the Administration’s invocation of the “nuclear option” declaring rising steel imports a threat to US national security – a development that stems less from steel trade in NAFTA than from excess steel capacity in China.5

Conclusion

The USTR’s list of NAFTA 2.0 objectives includes several reform proposals for which common ground between the three countries already exists, and for which the prior agreements of the Transpacific Partnership (and also the recently completed EU-Canada Comprehensive Economic and Trade Agreement) provide useful models. This includes proposals on customs and trade facilitation, sanitary and phytosanitary measures, technical barriers to trade, labour and environment, and digital trade.

However, the Trump Administration’s pronouncements on the “hard” issues noted above (trade balances, rules of origin, trade disputes) do not bode favourably for an amicable renegotiation between the three NAFTA countries in coming months.

Featured Image: Photo: (Left) President of Mexico, Enrique Peña Nietro, (Centre) President of the United States, Donald Trump, & (Right) Prime Minister of Canada, Justin Trudeau

David Bartlett is an Economic Adviser and Writer for RSM. He is Executive in Residence in the Department of Management at the Kogod School of Business, American University in Washington, DC. Bartlett’s research, teaching, and consulting focus on international corporate strategy with special attention to emerging markets and emerging technologies. He has published widely on these topics while leading interdisciplinary research projects on the global economy.

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